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These are bountiful days in U.S. shipyards, but the industry may be steaming into rough seas

After a decade-long decline in U.S. military shipbuilding budgets, from $11.5 billion in 1991 outlays to $6.7 billion in 2000, spending on ship construction is back to the $10 billion level. The Navy is building new generations of submarines, supply ships and expeditionary warfare vessels. The venerable Nimitz-class aircraft carriers and Arleigh Burke destroyers are still in production. Furthermore, new destroyer, aircraft carrier and littoral vessel designs are in development, moving quickly toward metal. Today, at some shipyards, the challenge is not finding more work but finding enough workers.

Today’s good times will roll for a while to come. The two major shipbuilders, General Dynamics and Northrop Grumman, at the end of 2005 reported a backlog of $26 billion worth of shipbuilding work — almost 2½ years of revenue. The Bush administration’s recent budget submission for fiscal 2007 to 2011 calls for almost doubling the number of ships being constructed. This indicates that the industry has visibility into its near-term future.

And the optimists would say that the longer-term outlook also is becoming clearer. After years of declining fleet sizes, the Navy’s latest 30-year shipbuilding plan calls for significantly increasing the number of ships in the U.S. fleet from the current 281 ships to 315 by 2012, and 330 by 2018. Even better, in their view, the long-skeptical Defense Department is on board. While the Quadrennial Defense Review didn’t mention concrete numbers for future fleet size, it endorses some major elements of the Navy 30-year plan, such as maintaining 11 aircraft carriers and procuring two attack submarines per year by 2012.

As one executive in the industry remarked publicly, “It would be churlish of me to complain.”

But talk to long-term planners, defense and financial analysts, and some on Capitol Hill, and you hear quite another story. The short-term glut of shipbuilding work is a just a passing flurry, they say. Trouble — big trouble — lies ahead for the industry. And they’re sailing into it, full speed ahead.

To the gloomy folks, the math is simple. The rising cost of ships inside a relatively static defense top line means that, at best, the Navy will be able to start nine new ships each year. However, not all ships are equal. Two-thirds of the planned new ships will be the smaller Littoral Combat Ships, and they are not being built in the major shipyards. So the best the industry can hope for is three or four new major combatant hulls and a few support ships a year — for six shipyards that have the physical capacity to build 40 ships a year (remembering that the industry is at capacity as far as labor is concerned).

And that arithmetic covers just the six privately owned shipyards, now concentrated in two firms, Northrop Grumman’s Newport News in Virginia, Ingalls in Mississippi and Avondale in Louisiana, and General Dynamics’s Bath Iron Works in Maine, Electric Boat in Connecticut and NASSCO in California. It does not count the four major government-owned shipyards, which the recent Base Closure and Realignment Commission left open — Portsmouth, Maine; Norfolk, Va.; Bremerton, Wash.; and Pearl Harbor, Hawaii. While the public yards mainly do repair work, they do compete with the major privately owned yards — the smaller ones, too — for that work and the associated budgets. So, the pessimists would note, the real mathematics are three or four new ships plus repair orders trying to keep 10 shipyards afloat. Any way you count ’em, the Navy has a lot of yards chasing just a little work.

NO EXIT

This is a problem that will be hard to solve. Of course, one way to solve the overcapacity issue would be to increase industry revenues. Navy plans call for an increase in the shipbuilding accounts to $14 billion a year, which would certainly be welcome to the industry and would solve many of its problems. But it’s probably too rosy a scenario.

Too rosy in two ways: First, that $14 billion level will be difficult to achieve given the internal pressures the Navy budget faces from constantly rising personnel costs, exploding health care costs, and mounting operations and maintenance expenses. Second, even if the $14 billion budget could be achieved, cost overruns in each of the programs still would limit the number of ships that could be built. Both translate into fewer numbers of ships being built.

Congress — and members from shipbuilding states populate the military committees in the House and Senate — does its best to help the Navy. Even though today’s political realities restrict Congress’ ability to add significant funds to the defense top line — as a Republican Congress is naturally reluctant to declare a Republican president’s budget insufficient — there are other ways to help. For example, traditional budget rules say that defense hardware has to be paid for in the year it is authorized. But with price tags for major naval combatants ranging from $1.5 billion to $5.6 billion, funding a ship in a single year crowds out a lot of other possible spending. So Congress has waived the rules, allowing ships to be bought on an easier annual installment plan (“gotta waive the rules in order to rule the waves”). Further use of incremental funding is being considered.

Sharing overhead by diversifying into commercial shipbuilding, a strategy used by the shipbuilding industry in the past to absorb excess capacity, is no longer a real option. The historical track record of commercial diversification by the naval shipbuilders has been disastrous. Each time the industry claims it has learned its lessons from the past and experiments with building oil tankers, cargo ships and cruise ships, the answer is the same: massive financial losses and write-offs. Today, Wall Street punishes any management team that even suggests re-entering the commercial shipbuilding market, and the current senior executives bear enough scars from prior endeavors that it is rarely considered.

THE UNTOUCHABLES

If increasing future demand significantly is constrained, the next logical option would be to reduce supply — let shipyards close. Although this has been done in the past, attempting to reduce the number of shipyards from their current numbers is fraught with political difficulty. As large employers in each of their respective states, shipyards bring along a lot of economic impact and votes. That gives Congress little inducement to rationalize the private or public shipyards, even if such rationalization is part of a comprehensive solution to the looming overcapacity problem. “Closing shipyards” is the defense equivalent of “reforming social security.”

And as with social entitlements, policy and politics are hard to rationalize. Congress and the executives of the individual shipyards have every incentive to compel the Navy to build ships in as many yards as possible. Most recently, contracts for the future destroyer, the DD(X), were changed from winner-take-all to multiple yards, largely because of pressure from concerned members of the House and Senate. Their concern usually is stated as “preserving the shipbuilding industrial base” — making sure that the United States has enough capacity to build the ships it needs here at home in case of a future naval threat. Advocates of multiyard contracts also point to the preservation of competition, and that ensuring there are two yards to build each class of ship is pro-competition.

Critics would say that with so few ships being built, it is hard to make a strong argument for retaining that much overcapacity. Furthermore, the logic of sustaining competition is put under strain when there are few future points of competition. In aircraft carriers, the Navy went to a monopoly supplier some time ago. And while Northrop Grumman and General Dynamics each own a submarine yard, the low rate of submarine production has led them to join in a teaming arrangement in which they function as a single yard, all the while keeping capacity available and awaiting a promised higher production rate.

Even Mother Nature seems to be on the side of the shipyards. The Hurricane Katrina disaster shifted the argument somewhat back to those who argue for distributed and redundant capacity. The impact the disaster had on the oil industry, which concentrated much of its oil transshipment and refining capacity on the Gulf Coast, as well as the damage to the naval shipyards in the region, was eye-opening to some. The benefits of efficiency versus the risk of single points of failure were cast in a new light. The redundancy argument, however, does not reduce the prospect of or imperative for reducing excess capacity and increasing efficiency within the yards (“shrinking in place”).

PROGRAM PERVERSITIES

The ability to increase the efficiency of the shipyards and reduce excess capacity in place runs into some perverse disincentives. The annual appropriations and contracting for ships makes it difficult for the shipyards to commit to long contracts with vendors. Therefore, any potential cost advantages gained from volume or long-term buying are constrained and less-than-optimal, let alone any savings gained from buying supplies for an entire class of ships. Furthermore, the ability to retain the savings generated and turn them into higher profits is limited by negotiated share lines and annual renegotiation of contracts. Lastly, the separation of budgets between the ship construction accounts and the operations and maintenance accounts creates artificial barriers that can distort trade-offs between installing a technology or product that costs more to manufacture but may result in considerable savings in future operations or maintenance.

Another set of perverse behaviors is a direct consequence of the low production rates. The massive infrastructure costs of the shipyards, the personnel overhead and all of the new technology being developed have to be absorbed in the price of a handful of ships each year. This, naturally, makes individual ships more expensive, shockingly so in some cases. Often, the reaction by Congress, to save money, is to stretch out the program or cut the number of ships to be bought. This forces the same nonrecurring costs to be spread over even fewer ships, further increasing the unit cost, shocking everyone further and raising suspicions of incompetence. Keep this downward spiral going for a few cycles and ultimately the program gets canceled because it is unaffordable. This tyranny of unit-cost budgeting is truly the bane of the Navy and the shipbuilding industry in a low production-rate environment.

DEATH BY ‘CAPABILITIES?’

Is the shipbuilding glass half full or half empty? The problem is the actors involved are looking at different glasses. Shipbuilders, the Navy and Congress want to build a lot of ships, each for different reasons. Continued production means continued employment for voters, longer-term amortization of existing shipyard assets and more sea command billets. The absolute number of ships becomes a key metric.

Others, such as, well, the secretary of defense, take a different view. They are less interested in the number of ships bought, preferring fewer hulls but building in greater capability. Defense Secretary Donald Rumsfeld told a December town hall meeting at the Pentagon that the size of the fleet does not matter, provided that it delivers the capabilities laid out in the Quadrennial Defense Review. In a budget-constrained environment, will a capabilities-based military be willing to shell out the nearly $3 billion per year extra required to meet the Navy’s shipbuilding goals? Time will tell.

Still, there must be something attractive about the business, as Boeing and Lockheed Martin — both much better known as aircraft makers — have recently gotten into shipbuilding, both competing on the Littoral Combat Ship program. But they did so in a different fashion, as systems integration firms, not shipyard owners. And they are focused on the next generation of ships, with exotic hull forms built of materials other than traditional steel. With their ability to inject technology and capital in new directions rather than being captive to older facilities and capabilities, the new neighbors’ arrival cannot be much comfort to the traditional shipbuilders.

But why complain when the yards are humming? Today’s a good day to be a shipbuilder. But tomorrow?

Pierre Chao is a senior fellow and director of Defense Industrial Initiatives, Jeremiah Gertler is a senior fellow in the International Security Program, and Seth Seifman is a research associate in the International Security Program, all at the Center for Strategic and International Studies in Washington, D.C.